Engineering Economic Analysis

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546 ACCOUNTING AND ENGINEERINGECONOMY

Financial Ratios Derived from Income Statement Data

Interest coverage, as given in Equation 18-6, is calculated as the ratio of total income to

interest payments-where total incomeis total revenues minus all expenses except interest

payments.

Interest coverage =Total income/Interest payments (18-6)

The interest coverageratio (which for industrial firms should be at least 3.0) indicates

how much revenue must drop to affect the firm's ability to financeits debt. With an interest

coverage ratio of 3.0, a firm's revenue would have to decrease by two-thirds (unlikely)

before it became impossible to pay the interest on the debt. The larger the interest coverage

ratio the better. Engineered Industries in Figure 18-3 has an interest coverage ratio of

(28,610,000 - 17,250,000)/120,000 =94.7

Another importantfinancialratio based on the income statement is the net profit ratio.

This ratio (Equation 18-7)equals net profits divided by net sales revenue.Net sales revenue

equals sales minus returns and allowances.

Net profit ratio=Net profit/Net sales revenue (18-7)

This ratio provides insight into the cost efficiency of operations as well as a firm's

ability to convert sales into profits. For Engineered Industries in Figure 18-3, the net profit

ratio is 7,310,000/28,030,000 = 0.261 = 26.1%. As with other financial measures, the

net profit ratio is best evaluated by comparisons with other time periods and industry

benchmarks.

Linking the Balance Sheet, Income Statement, and Capital Transactions

The balance sheet and the income statement are separate, but linked documents. Under-

standing how the two are linked together helps clarify each. Accounting describes these

links as thearticulation between these reports.

The balance sheet shows a firm's assets, liabilities, and equity at a particular point in

time, whereas the income statement summarizes revenues and expenses over a time interval..

These tabulations can be visualizedas a snapshot at the period's beginning (a balance sheet),

a video summary overthe period (the income statement),and a snapshot at the period's end

(another balance sheet).The income statement and changesin the balance sheets summarize

the business transactionsthat have occurred during that period.

There are many linksbetween these statementsand the cash flowsthat make up business

transactions, but for engineering economic analysis the followIng are the most important.

1. Overall profit or loss (income statement) and the starting and ending equity (balance
   sheets).


2. Acquisition of capital assets.


3. Depreciation of capital assets.

The overall profit or loss during the year (shown on the income statement) is reflected

in the change in retained earnings between the balance sheets at the beginning and end of